Why low interest rates are doing more harm than good

05 September 2016

Low interest rates have become a way of life across much of the developed world, but former Bank of England Monetary Policy Committee member Andrew Sentance, Professor of Practice in the Economic Modelling & Forecasting group, writes for The Telegraph that it is time for a re-think. The article is reproduced below.

Since the financial crisis, we have become used to living in a world of low interest rates. The official Bank of England interest rate was cut to 0.5 per cent over seven years ago and now it has been reduced further to 0.25 per cent.

Until recently, it was possible for long-term investors to earn better returns and protect themselves against inflation by investing in government bonds. That is no longer the case.

In 2010, a 20-year UK Government bond was still offering an annual yield of four per cent significantly above the two per cent inflation target. Yields dropped to between 2.5 per cent and three per cent following the euro crisis, but even at these rates they could be expected to generate a small positive return in real terms.

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Following the Brexit referendum result and the Bank of England’s latest 'stimulus package', however, even these small positive returns have disappeared.

Mark Carney has said he does not envisage the Bank of England setting a negative interest rate, but from the perspective of long-term investors like pension funds and insurance companies we are already in a world of negative returns.

Long-term investors can no longer protect themselves against inflation by buying government bonds. Ten-year UK Government bonds now offer a cash return of just 0.7 per cent, with a 20-year bond paying just over one per cent. If inflation returns to the two per cent target, as expected, these returns are negative in real terms.

Long-term bond yields are not just low by recent standards, they are the lowest returns we have seen in the UK since the Bank of England was founded in 1694.

The previous low-point for UK Government long-term bond yields was at the end of the 19th century when they dropped to just below two per cent. The long-term average return on UK Government bonds since the 1700s has been around 4.5 per cent (before taking into account inflation) and this was the yield which investors were receiving in the years immediately before the financial crisis.

Why have long-term interest rates fallen to such extremely low levels? The obvious explanation is the very stimulatory monetary policies pursued around the world since 2009. This has led to a prolonged period of extremely low official interest rates, and large purchases of government bonds by central banks. Both of these policies depress government bond yields. 

After more than seven years of record low interest rates, there is little sign of a return to more normal monetary policies. And the reaction of central banks to negative shocks – such as the euro crisis or Brexit – is still to find ways of providing more monetary stimulus.

The markets have concluded that for now there is little prospect of a change in this approach, with the possible exception of a slow and gradual rise in US interest rates. That helps to explain why the yield on US Treasury bonds has held up when the return on government bonds has collapsed in the UK and the euro area.

Image: Bank of England
Decision time: Governor Mark Carney talking on the MPC

Quantitative Easing (QE) is also acting as a persistent and prolonged dampener on long-term yields. Central banks have stepped in to create an artificial demand by buying up vast quantities of government bonds, depressing returns.

Investors may now conclude that if central banks are prepared to exchange government bonds for money so readily, why should the bonds they buy earn any sort of premium over cash – which has a zero return?

It is not surprising that the Bank of England’s latest QE programme has triggered the latest downwards lurch in government bond yields.

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When ultra-low interest rates and QE were first deployed in the UK and other major economies in 2009, they were seen as temporary policies to dig us out of the hole created by the financial crisis. Now these policies are seen as a semi-permanent feature of the economic environment – until there is a significant change in the approach to monetary policy in the world’s major economies.

There are, however, adverse long-term consequences from this approach to monetary policy. Today’s world of historically low bond yields and negative real interest rates creates a massive headwind for individuals trying to build up long-term savings for retirement.

We can see this in the financial health of UK pensions funds, which are heavy investors in government bonds. The latest assessment by PwC shows that pension fund deficits have expanded by £100 billion over the past year to total £700 billion – a “debt” of £26,000 per household in the UK.

At a time when we should be developing policies to help deal with an ageing population, monetary policy is creating incentives in totally the wrong direction.

The level of interest rates and associated policies like QE are still geared to help those who want to borrow whether they are individuals, companies or government.

When the chief economist at the Bank of England advises individuals to “invest in property not pensions", as Andy Haldane did last weekend, there is something seriously wrong.

Current policies are discouraging long-term saving and businesses are being forced to divert resources away from productive investment to support ailing pension funds.

What is the way out of this impasse? First, we must stop digging and making the financial hole any bigger. I argued a few weeks ago that the Bank of England’s reaction to the Brexit vote was premature. If it becomes clear that the latest rate cut and QE injections were unnecessary, they should be reversed.

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Second, we need a co-ordinated international approach to restoring a more normal level of interest rates and gradually reversing the large bond holdings of central banks built up by QE.

At the Jackson Hole meeting of central bankers last weekend, there was little sign that this is on the agenda at the moment. They are still preoccupied with short-term fire-fighting.

We need a much longer-term strategy from governments and the central banking community to rebalance economic policies with more emphasis on supply-side reforms and business-friendly fiscal policies to support growth.

Record low government bond yields are signalling an important message: the negative consequences of a prolonged period of very low interest rates are starting to outweigh the benefit provided in terms of economic stimulus.

It is time for a total rethink on the direction of monetary policy, not just in the UK but worldwide. There will be serious long-term consequences for our economy if this does not happen soon.

Read the original article at The Telegraph.

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